ESG Ratings and Materiality Concepts

ESG Scores Overview

• ESG scores (Environmental, Social, and Governance) rate companies' performance on sustainability
• Scores are determined by third-party vendors specializing in ESG ratings (e.g., Moody's, ISS, MSCI, Sustainalytics, S&P Global)
• ESG scores are not standardized, unlike traditional credit ratings
• Rating agencies are often paid by investors, not the companies being rated
• This creates an information asymmetry between those knowing the truth and investors

ESG Financial Ecosystem

• ESG financial ecosystem is a complex chain of actors and processes
• Issuers disclose information relevant to ESG factors and materiality
• Rating providers assess and rate issuers on ESG performance
• Indices construct ESG indices based on company ratings by providers
• Asset managers construct and market ESG products (funds, ETFs)
• Institutional investors manage assets with fiduciary responsibilities using ESG factors
• End investors invest in assets based on ESG factors
• Rules and requirements include exchanges, self-monitoring entities, and regulators
• There are ethical standard setters, international bodies, and guidelines on responsible conduct and societal values

Raw and Refined ESG Data

• Analyst-driven ESG research uses structured data models
• Data collection involves using ESG data miners and technology, and collecting data from structured and unstructured sources
• Analysts process the data to derive structured data
• Algorithms then generate ESG scores/ratings from extracted signals using data analysis
• Technology is instrumental in this process

Complex Data Ecosystem overview

• A complex, multi-faceted data ecosystem exists for ESG data
• Companies provide sustainability reports, annual reports, and other information.
• NGOS, Media and other parties provide additional information about the company and issues related to them.
• Intermediaries like rating agencies, data providers, rankings, and indexes provide further processed and/or normalized data, which is then made available to broker-analysts and asset managers for further use by investors.
• Investors use the data in their investment decisions and recommendation

Data Service

• Bloomberg announced a new data offering on its terminal related to the EU's CSRD (Corporate Sustainability Reporting Directive)
• The data offering collates information reported by companies that aligns with EU CSRD guidelines.
• The offering collects historical data from companies.
• This offering is intended for use by enterprises on a large scale.
• Data provided covers financial and impact materiality and is based on a mapping between European Sustainability Reporting Standards and existing Bloomberg data fields
• Additional data fields will be created to fulfill regulations.

What Are ESG Scores?

• Good ESG rating shows a company well manages its Environmental, Social, and Governance (ESG) risks relative to peers.
• Poor rating signals higher mismanagement of these risks.
• Ratings range from CCC (worst) to AAA (best), showing a relative performance on risks management .

What Are Rating Agencies?

• Rating agencies are third-party organizations that measure ESG performance.
• They base this on publicly available information, industry standards, and methodologies.
• Unlike traditional credit rating agencies, these agencies are typically paid by investors to get these assessments for investments in their portfolios, not companies themselves.
• ESG agencies have varying standards and criteria, making comparisons difficult.

What Do Scores Measure?

• Credit ratings assess the probability of a borrower defaulting on their liabilities.
• ESG ratings analyze a company's ability to manage Environmental, Social, and Governance risks.
• Credit and ESG ratings use different assessment methods, with credit ratings having higher correlation (>90%) and greater stability than ESG ratings which demonstrate lower correlation (<40%).

What Do Scores Should Measure?

• Some approaches to score measurement emphasize a "single-materiality" approach for CSR (corporate social responsibility) focusing solely on risks and opportunities relevant to a company's ability to create worth.
• Others prefer a "double-materiality" approach, considering both the financial impact of ESG factors on the company and the company's impact on society/the environment .

What Do ESG Scores Actually Measure?

• ESG ratings show a company's exposure to environmental, social, and governance risks.
• These ratings attempt to show how well a company handles these risks.
• ESG ratings can help investors and stakeholders determine if a company's social and environmental policies and practices might either boost their shareholder returns, or be destructive.

ESG Scoring is about Finance Not Impact

• ESG scoring isn't inherently about improving the world.
• Its primary function is to assess the risks and opportunities presented by ESG factors within investments so that investors can choose the best risk/return.
• ESG factors in investment mean more, because today it is understood that investors care about ESG.

Rating Process Involves Three Activities

• Materiality: Determining relevant ESG indicators by looking at the company within its sector(industry), and considering how its activities might impact that sector and the environment.
• Data harvesting: Gathering information from various sources, which may include data from public disclosures (company filings), non-governmental organizations (NGOs), social media, and other data sources.
• Scoring: Weighing and evaluating company commitments, implementation plans, and performance, regarding these commitments and plans(policies, strategy, actions)

Materiality

• Materiality assesses factors considered essential to a company's long-term financial success or potentially creating legal, regulatory, reputational, or other major risks.
• Materiality may differ based on the industry and company, making it not truly universal or consistent.

Scores Based on Materiality (Example - MSCI)

• ESG scores are often based on the determination of what is material in a particular industry for a company(relative to its peers)
• The scores may be weighted based on impact across the different pillars (Environmental, Social, Governance).
• Different industries/companies may have different issues with weightings reflecting the factors relevant to particular sectors/companies, hence the weighting may not be the same between sectors or companies.

How to Know Which ESG Issues are Financially Material?

• There's no universal standardized list of financially material ESG issues for every company.
• Company materiality is assessed based on a company's specific industry, business model, operations, competition and current circumstances (the context of the assessment).
• The context, environment, and approach for these assessments vary based on companies' jurisdiction (e.g., a company's business headquarters or overseas operations), legislation, and regulatory responsibilities.

Data Harvesting

• Information for ESG assessment comes from a wide range of sources, including company filings, regulatory documents, NGO data, media reports and internal/proprietary data bases
• Imputation (filling in missing information) is a data assessment practice employed by rating agencies
• Statistical methods, such as regression models, are used to fill in data.

Cross-Cutting Standards

• Several standards have been defined regarding what factors/activities need to be used to perform ESG risk assessment
• These comprise general principles, environment, social, and governance aspects, such as climate change, pollution, water resources, and biodiversity for the environmental aspects.
• Social aspects include the workforce, communities, consumers, and end-users.
• Governance, which covers the business conduct (e.g., ethical behavior and business integrity) of the company

Is It Possible to Have Standard ESG Metrics for PE?

• Various metrics are proposed for ESG evaluation to measure environmental, social, and governance performance.
• These include carbon footprint measures, volunteering, gender pay gaps, and diversity, among others
• Specific examples are given for these measures, and the necessity of them.

MSCI ESG Score Process

• There is a three-step process for scoring companies with MSCI ESG ratings: Gathering/Collecting, evaluating, and rating/Scoring.
• MSCI use data (3,400 media sources) to determine a standard ESG methodology for risk assessments
• They use a standardized methodology for assessing a company's ESG risk exposure and management, in relation to industry peers.
• The evaluation involves industry-specific key issues with a (0-10) scoring system on a rules-based methodology
• ESG ratings are reviewed frequently due to company activity and potential controversies.

Refinitiv ESG Score Process

• ESG data is collected and evaluated under three major categories: Environmental, Social, and Governance.
• ESG scores/ratings use a combination of publicly available data on the company, and internal data/algorithms
• ESG controversies affecting all ten categories are aggregated into one category score
• The data points used can be financial or non-financial

Data Evolution

• ESG data is necessary for sustainable finance and is constantly evolving alongside new needs and technologies.
• The evolution of ESG data is largely influenced by the emergence of AI, updated regulatory frameworks, and the evolving needs of practitioners.

ESG Rating Regulation

• The EU has set up a regulation on ESG ratings, with greater transparency requirements on methodologies and data sources
• It mandates separate ratings for environmental, social and governance factors.
• A standardized measure of double materiality (both company impact and impact on the company are assessed to define materiality) should be communicated in the context of ESG ratings

ESG Analyst

• ESG analysts monitor and analyze environmental, social, and governance (ESG) issues relevant to companies for potential investment decisions or portfolio risk management

ESG Analyst Job Offer

• Preparation of impact and ESG assessments for companies
• Supporting portfolio managers with ESG/impact assessments
• Guiding companies for improvement in sustainability practices

Ratings Correlations

• Companies have been given disparate ratings from rating agencies
• Methods of rating assessment differ among agencies.
• Issues with criteria (scope) are problematic, and have a problem with inconsistency and lack of standardized criteria

Rating Agencies and Controversies

• Rating agencies collect and filter controversies, and rate them based on severity
• Severity is determined by factors like how significant were the events, the impact on society, and the company's response(handling).
• Controversies are filtered through methodologies by various ESG Rating Agencies.

Controversies and the Banking/Oil Sector

• The banking and oil sectors show up in the top twenty most criticized companies because of alleged controversies related to, a lack of efficiency in the fight against money laundering or corruption, and a suspicion of encouraging tax evasion.

Case Study: Pharma Sector

• The pharmaceutical industry frequently faces controversies concerning corruption and unethical practices
• These may lead to legal ramifications and a decline in stock price (or damage to reputation).
• The pharmaceutical industry faces many challenges, like pricing (drugs/medication), regulatory hurdles, uncertain demand from customers (patients), generic variants, and sales and marketing costs.

Pharma Strategic Challenges

• Pharmaceutical companies invest heavily in R&D(research and development).
• The return from innovation is increasingly declining over time.
• Companies face significant pressure to demonstrate the true value of new medications to justify investments in R&D.
• Side effects are a significant risk and increase sales and marketing costs.

CSR Risk Drivers in Pharma

• False innovation of medications.
• Scientific frauds concerning new products.
• Lobbying and corruption.
• Aggressive marketing for products(to increase sales).
• Denial of the presence of side effects of products.

A Controversial Industry

• Pharmaceutical companies face many controversies relating to product safety.
• There is a lack of transparency about companies' activities and products.
• Anti-competitive practices negatively impacting consumers.
• Corruption is a significant risk in the pharmaceutical industry.

Inconsistent ESG Ratings

• ESG ratings are not always consistent across different agencies.
• There isn't a single unified methodology, which leads to different levels of ratings affecting investments decisions.

Pharmaceutical Margin Performance

• Pharmaceutical companies demonstrate higher margins when compared to other types of companies in their categories.

Takeaways

• Pharmaceutical industry business models are increasingly exposed to risks from ESG concerns.
• Existing ESG agencies and ratings are inconsistent and lack sufficient standards/methodologies for evaluation purposes(leading to inaccurate ESG assessments)
• Inclusion of pharmaceutical companies in SRI portfolios is frequently not based on sound examples of CSR/ESG strategies.

Appendices

• Data collection methods
• Rating methodologies among agencies
• Data on controversies among diverse ESG Rating Agencies

This quiz explores the fundamental concepts surrounding Environmental, Social, and Governance (ESG) ratings. It delves into how these ratings are determined, the materiality of ESG issues, and the challenges faced in the evaluation process. Test your knowledge on the differences between ESG and traditional credit ratings.